The Fundamentals of Business Financing

There are several options, each with advantages and disadvantages.

What Exactly Is Business Financing?

Unless your company has the balance sheet of like Apple’s, you will most likely require capital through business financing at some point. Even many large-cap businesses frequently look for capital infusions to meet short-term obligations.

Finding a suitable funding model is critical for small businesses. If you borrow money from the wrong place, you risk losing a portion of your business or being locked into repayment terms that will stifle your growth for years to come.

Key Takeaways

There are several options for small business financing.

Debt financing is typically provided by a financial institution, with regular monthly payments required until the debt is paid off.

In equity financing, a company or an individual makes an investment in your company, which means you don't have to pay it back.

However, the investor now owns a stake in your company, possibly even a controlling stake.

Mezzanine capital combines debt and equity financing, with the lender typically having the option to convert unpaid debt into company ownership.

What Exactly Is Debt Financing?

Debt financing for your business is probably something you know more about than you think. Do you have a mortgage or a car loan? These are both types of debt financing. The same is true for your company. Debt financing is provided by a bank or another lending institution. Although private investors may offer you this, it is not common.

This is how it works: You go to the bank and fill out an application when you decide you need a loan. If your company is still in its early stages, the bank will check your personal credit.

Banks will look into other sources for businesses with a more complicated corporate structure or that have been in operation for a long time. One of the most important is the Dun & Bradstreet (D&B) file. D&B is the most well-known company for compiling a business's credit history.

The bank will want to check your books and probably perform other due diligence in addition to looking at your business's credit history.

Check that all business records are complete and organized before applying. If your loan request is approved, the bank will set up payment terms, including interest. You are correct if the process sounds similar to the one you have gone through numerous times to obtain a bank loan.

Benefits of Debt Financing

There are several benefits to financing your business with debt:

● The lending institution has no say in how you run your business and has no ownership.

● When you repay the loan, your relationship with the lender is over. This is especially important as your company grows in value.

● Debt financing interest is tax deductible as a business expense.

● The monthly payment, as well as the payment breakdown, is a known expense that can be accurately accounted for in your forecasting models.

The Drawbacks of Debt Financing

However, debt financing for your business has some drawbacks:

● Including a debt payment in your monthly expenses assumes that you will always have enough cash to cover all business expenses, including the debt payment. That is frequently far from certain for small or early-stage businesses.

● During a recession, small business lending can be significantly slowed. Unless you are extremely qualified, it can be difficult to obtain debt financing during difficult economic times.

CAUTION

Small businesses may find it more difficult to obtain debt financing during economic downturns.

The Small Business Administration (SBA) of the United States collaborates with specific banks to provide small business loans. A portion of the loan is backed by the credit and full faith of the United States government. These loans offer debt financing to business owners who might not otherwise be eligible, with the goal of lowering the risk for lending institutions.

More information about these and other SBA loans can be found on the SBA's website.

How Does Equity Financing Work?

If you've ever seen ABC's hit show "Shark Tank," you may have a general understanding of how equity financing works. It is provided by investors known as "venture capitalists" or "angel investors."

A venture capitalist is typically a corporation rather than an individual. The partners of the firm, along with teams of lawyers, accountants, and investment advisors, conduct due diligence on any potential investments.

Because venture capital firms frequently deal in large investments ($3 million or more), the process is lengthy, and the transaction is frequently complex.

Angel investors, on the other hand, are typically wealthy individuals who prefer to invest a smaller sum of money in a single product rather than building a business. They are ideal for software developers who require capital to fund product development. Angel investors want simple terms and want to move quickly.

Warning

An investor, not a lender, is used in equity financing. If you declare bankruptcy, you owe nothing to the investor, who, as a part owner of the company, simply loses their investment.

Benefits of Equity Financing

There are several advantages to funding your business through investors:

● The main advantage is that you do not have to repay the money. Your investor or investors are not creditors if your company declares bankruptcy. They are part owners in your company, and as a result, their money is lost along with yours.

● Because there are no monthly payments, there is usually more liquid cash on hand for operating expenses.

● Investors understand that building a business takes time. You will receive the funds you require without the stress of having to see your product or company thrive in a short period of time.

The Drawbacks of Equity Financing

Similarly, equity financing has several drawbacks:

● What are your thoughts on finding a new partner? Raising equity financing entails giving up ownership of a portion of your company. The larger and riskier the investment, the larger the stake the investor will want. You may have to sell 50% or more of your company. That partner will take 50% of your profits indefinitely unless you later negotiate a deal to buy the investor's stake.

● Before making any decisions, you should consult with your investors. Your company is no longer solely yours, and if an investor owns more than 50% of it, you now have a boss to whom you must report.

How Does Mezzanine Capital Work?

Consider yourself in the shoes of the lender for a moment. The lender is looking for the best return on investment with the least amount of risk. The issue with debt financing is that the lender does not profit from the company's success. It only receives interest on its money while risking default. By investment standards, that interest rate will not provide an impressive return. It will most likely provide returns in the single digits.

Mezzanine capital frequently combines the best aspects of both equity and debt financing. Although there is no standard structure for this type of business financing, debt capital frequently gives the lending institution the right to convert the loan into an equity interest in the company if you do not repay it on time or in full.

The Benefits of Mezzanine Capital

There are several advantages to using Mezzanine capital:

● This loan is appropriate for a new company that is already showing signs of growth. Banks may be hesitant to lend to a company that lacks three years of financial data.

● A newer business, on the other hand, may not have as much data to provide. By including the option to purchase a stake in the company, the bank gains more security, making the loan easier to obtain.

● On the balance sheet, Mezzanine capital is classified as equity. Displaying equity rather than a debt obligation makes the company appear more appealing to potential lenders.

● Mezzanine financing is frequently provided quickly and with little due diligence.

Mezzanine Capital's Disadvantages

Mezzanine capital has some drawbacks:

● The coupon or interest rate is frequently higher because the lender considers the company to be high-risk. Mezzanine capital provided to a business with existing debt or equity obligations is frequently subordinated to those obligations, increasing the risk that the lender will not be repaid. Because of the high risk, the lender may expect a return of 20% to 30%.

● The risk of losing a significant portion of the company is genuine, just like the risk of losing equity capital.

Please keep in mind that Mezzanine capital is not as common as debt or equity financing. The transaction, as well as the risk/reward profile, will be unique to each party.

Off-balance-sheet financing is useful for one-time large purchases because it allows a company to create a special purpose vehicle (SPV) that carries the expense on its balance sheet, making the company appear less in debt.

Off-Balance-Sheet Financing

Consider your own personal finances for a moment. What if you were applying for a new home mortgage and discovered a way to create a legal entity that removed your student loan, credit card, and automobile debt from your credit report? Businesses can do this.

Off-balance-sheet financing is not the same as a loan. Its primary purpose is to keep large purchases (debts) off a company's balance sheet, making it appear stronger and less indebted.

For example, if the company needed expensive equipment, it could lease it rather than buy it, or it could set up a special purpose vehicle (SPV)—one of those "alternate families" that would record the purchase on its balance sheet.

If the SPV needs a loan to service its debt, the sponsoring company frequently overcapitalizes the SPV to make it seem desirable.

Off-balance-sheet financing is strictly regulated, and generally accepted accounting principles (GAAP) govern its application. The majority of businesses cannot benefit from this type of financing, but small businesses that expand into much larger corporate structures may be able to use it.

Family and friends' contributions

If your funding requirements are modest, you may want to start with less formal sources of funding. Family and friends who support your business can offer amiable and clear repayment terms in return for creating a lending model that resembles some of the more formal models. You could, for example, offer them stock in your company or repay them in the same way that you would a debt financing deal, in which you make regular payments with interest.

Using Retirement Accounts

In contrast to the option of borrowing from your retirement plan and repaying the loan with interest, a Rollover for Business Start-ups (ROBS) has emerged as a viable source of funding for those starting a business.

When properly implemented, ROBS enables business owners to put their retirement money into a new project without having to pay taxes, early withdrawal penalties, or loan costs.

However, due to the complexity of ROBS transactions, working with a knowledgeable and experienced provider is essential.

Frequently asked questions

How Do You Fund a Business?

Your new business can be financed in a variety of ways. You could borrow money from a reputable lender, ask loved ones and friends for assistance, raise capital through investors, or even withdraw funds from your retirement accounts, though the latter choice is not recommended.

What Is Equity Financing?

The process of raising money by selling company stock falls under this category of financing. Your investors will acquire a stake in your business if you do this.

Can I Use My 401(k) to Start a Business?

You can borrow from your 401(k), but how wise it is depends on your circumstances. Most plans limit withdrawals to $10,000 or 50% of your vested balance (whichever is greater), but there is a $50,000 limit.

Your account must be repaid according to strict guidelines. If you go this route, make certain that you can repay yourself. Taking out a loan to fund a start-up can be risky because you must continue to work for your current employer. If you leave with a loan on your plan, you must repay the loan as well as any taxes and penalties for leaving early.

In conclusion

Generally speaking, if you can avoid getting financing from a formal source, it will be better for your company. Debt financing is likely the most accessible source of funds for small businesses if you do not have family or friends who can assist.

Depending on how quickly your company grows or where it is in the product development process, equity financing or Mezzanine capital may be viable options. Less is more in terms of financing and the impact it will have on your company.